9/19/2005 @ 6:00AM

Seeding The Hedge Fund Universe

A crowded field and shrinking profit seem only to have whetted the ambitions of would-be hedge fund managers looking to strike out on their own.

But the hot money now isn’t in the hedge funds. It’s in backing new funds–hedge fund incubators.

With new regulatory requirements and the tougher demands of pension funds and other institutional investors, new hedge fund managers are flocking to incubators, or seed capital firms, for that extra startup boost. What they get is what any good fledgling hedge fund needs–a lot of money, a lot of technology and office resources in a very short period of time.

In fact, this business is so good it’s beginning to look as if the best career move isn’t to start your own hedge fund but to back others–become a seed investor or the manager of a fund of funds focused on startup hedges. At Capital Z, a New York hedge fund incubator, some 800 proposals for new hedge funds arrive over the transom every year, many of them never getting off the ground.

For the ones that do, “it’s never a slam-dunk,” says Elizabeth Flisser, Capital Z’s partner in charge of monitoring its seedling funds. But at least for incubators like Capital Z, they can spread their risk across a whole array of funds–they only need a few to hit it big.

Like other seed investors, Capital Z will put up $25 million or more in a new fund or an established fund that needs to gain some traction, but for a price. Seed investors get breaks on the fund management fees, often take a minority stake in the funds, join their boards, negotiate for relaxed restrictions on redemptions and demand certain performance targets. Some even demand the fund manager set up shop in their offices so they can be monitored closely.

Considering a hedge fund’s performance is often at its peak in its first three years, that’s not a bad investment. SG Asset Management, a unit of French bank Societe Generale, just created a $1 billion fund to back new hedge funds and plans to sink the money into ten managers over the next 18 months. It joins a long list of seed firms, many of them owned or backed by banks or insurance companies, that are scouring the markets for the next big fund management star.

That’s not always as easy as it sounds. Charles Gradante, a principal at Hennessee Group, says that 20 years ago, when there weren’t too many hedge funds around, it was relatively easy to identify the star managers–they were people with last names like Soros and Robertson. “There’s a whole new crop of managers to evaluate, and they are not as notorious” as those earlier names, Gradante said.

For a Soros wannabe, it’s getting more important to make that big splash early on. Institutional investors like pension funds often have restrictions on how large a percentage of any one fund they can hold, pushing little funds of $5 million or so below their investment radar screens. With a base of $25 million to $50 million, it’s easier to attract pension fund money.

“As regulations evolve requiring more hedge fund managers to register with the SEC as investment advisers, nascent managers may look with greater frequency to seed investors to provide infrastructure to help with compliance,” says Ron Geffner, partner at Sadis & Goldberg, which specializes in hedge funds.

Geffner says it’s getting more difficult for hedge fund managers to attract the interest of seed investors, who prowl beauty pageants sponsored by prime brokers, as well as conferences, and use word-of-mouth to find promising managers.

“We pick credible teams with track records and try to duplicate that place for them,” said Amir Farman-Farma, director of the emerging-manager program at Fortune Group, which has helped to seed several managers since 2002, including a former Soros money runner, Simon Nocera, who now operates the $100 million Lumen Global Value Fund.

Fund managers who get seed money “can have a much longer longevity and success” than those who just start up on their own, said Paul DiFrancesco, the president of Decision Capital Management in La Jolla, Calif. DCM is a seed firm that is helping a team get started in Greenwich, Conn., with an initial injection of $10 million and a promise to put up another $15 million if they do well in the next six months.

Such seeded funds get an immediate advantage, DiFrancesco says. “They achieve the first level of critical mass for marketing,” he notes.

That’s a point for hedge fund investors. With so many strategies to sort through, knowing that a fund is backed by a seed firm or an incubator “is another data point,” Gradante said, and means there’s a greater chance a fund manager will have someone watching over his shoulders.